When it comes to making decisions, there are a whole host of factors that have an influence. It is no different with financial decisions, including investing. While we know they should be based on logic, it is inevitable that emotions and previous experiences creep in during the process, affecting the choices we make.
Understanding that bias naturally occurs and how behavioural psychology has an impact on the decision-making process can help you reduce how much it influences your investment decisions. Successful investing requires you to avoid the psychological traps that can occur when making financial arrangements. When you think back to investment decisions you have made, you may not even realise how psychology has affected the outcome, making it difficult to mitigate.
There are many ways that behavioural psychology may affect investment decisions. The four biases detailed below can help you see how your past financial experience and personal attitude may be affecting how you decide to invest money.
Loss aversion: Would you rather not lose £100 or win £100? For many people, they would rather take the certainty of not losing money they already have over potential gains in the future. It appeals to our fear that something may happen that means we lose out. From an investment perspective, loss aversion may mean you are holding too much in cash. Alternatively, it may influence when you decide to sell; you may hold on to an investment that is losing too long in the hope they will recover or sell as soon as they deliver a return, for instance.
Confirmation bias: Sometimes referred to as anchoring, confirmation bias acknowledges our tendency to seek out opinions that match our own or place more validation on them. With so much information available online, it is often an easy task to find something that agrees with us. However, if you focus on the opinions that support a view you have already established it can result in decisions that are skewed. Simply being aware of this can help you take on a wider range of sources and question which ones are the most reliable.
Sunk costs: Do you know when to cut your losses? When you have invested money into a particular area, it can be difficult to know what the right time to get rid of the holding is. It can be a challenging decision to make at any point, but the theory of sunk cost fallacy builds on this. If you have already lost money, it can be difficult to accept this and walk away from the investment. However, sticking with it in the hopes of benefiting from a recovery when logic suggests this is not going to happen may compound losses further.
Familiarity bias: It is often said that you should stick to what you know. However, if this is preventing you from diversifying when it comes to investments, it can leave you more exposed to market volatility. Familiar investments can mean you feel more secure, but in reality, it may not be the case.
It is natural to worry about putting your money in investments you do not entirely understand or are familiar with. Taking the time to learn more about alternative investments can be a good place to start here. Working with a financial planner can also provide a solution and give you the confidence to create a diversified investment portfolio that is built with your objectives in mind.
Building a financial plan based on reason
Building a financial plan provides a great base for ensuring financial decisions are made from a logical point of view.
Having a clearly defined plan in place that reflects your goals gives you a course to stick to. It can reduce the chance of you making a rash decision that could harm your financial security. When the value of investments fall, for example, it can be tempting to make a knee-jerk reaction to withdraw your money. However, knowing you have a plan in place that takes into account short-term market volatility will give you the confidence to stick to it.
Of course, a financial plan can be influenced by bias and other factors too. This is where working with a professional can provide you with a different perspective. By talking through your objectives with someone on the outside, you can minimise the chance of getting caught in psychological traps. With a professional’s help, you are in a better position to build a financial plan that you can rely on.
When you want to make changes to your financial plan, a professional can help you identify the reason behind this too. In some cases, updates are essential, but there are occasions where the wish to make changes are driven by bias and fears that are not based on the facts.
To talk to one of our experienced financial planners about your aspirations and plans, please contact us. Our goal is to work with you to put a financial plan in place that you can have confidence in the short, medium and long term.